SUPPLY AND DEMAND : HOW MARKETS WORK

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1 SUPPLY AND DEMAND : HOW MARKETS WORK Chapter 4 : The Market Forces of and and demand are the two words that economists use most often. and demand are the forces that make market economies work. Modern microeconomics is about supply, demand, and market equilibrium. MARKETS AND COMPETITION A market is a group of buyers and sellers of a particular good or service. The terms supply and demand refer to the behavior of people... as they interact with one another in markets. Buyers determine demand Sellers determine supply Competitive Markets A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. Perfect Competition Products are the same Numerous buyers and sellers so that each has no influence over price Buyers and Sellers are price takers Monopoly One seller, and seller controls price Oligopoly Few sellers Not always aggressive competition Monopolistic Competition Many sellers Slightly differentiated products Each seller may set price for its own product DEMAND demanded is the amount of a good that buyers are willing and able to purchase. Law of The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises. The Curve: The Relationship between and ed Schedule The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. 1

2 Catherine s Schedule The Curve: The Relationship between and ed Curve The demand curve is a graph of the relationship between the price of a good and the quantity demanded. Market versus Individual Market demand refers to the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve. of Ice-Cream Cone $ A decrease in price of Ice-Cream Cones 2... increases quantity of cones demanded. 2

3 Shifts in the Curve Change in ed Movement along the demand curve. Caused by a change in the price of the product. Changes in ed of Ice-Cream Cones $2. B 1. A D 4 8 of Ice-Cream Cones of Ice cream Cone Increase in demand Decrease in demand curve, D 3 curve, D 1 curve, D 2 of ice-cream cone 3

4 Shifts in the Curve Consumer income s of related goods Tastes Expectations Number of buyers of Ice- Cream Cone $ Increase in demand An increase in income... Consumer Income: Normal Good.5 D 1 D 2 of Ice-Cream Cone $ An increase in income... of Ice-Cream Cones Decrease in demand Consumer Income: Inferior Good.5 D 2 D of Ice-Cream Cones 4

5 Change in A shift in the demand curve, either to the left or right. Caused by any change that alters the quantity demanded at every price. Consumer Income As income increases the demand for a normal good will increase. As income increases the demand for an inferior good will decrease. s of Related Goods When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. When a fall in the price of one good increases the demand for another good, the two goods are called complements. Table 1 Variables That Influence Buyers SUPPLY supplied is the amount of a good that sellers are willing and able to sell. Law of The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises. The Curve: The Relationship between and Supplied Schedule The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. Ben s Schedule 5

6 Curve The supply curve is the graph of the relationship between the price of a good and the quantity supplied. Market versus Individual Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve. Shifts in the Curve Input prices Technology Expectations Number of sellers Change in Supplied Movement along the supply curve. Caused by a change in anything that alters the quantity supplied at each price. of ice-cream cone $3. 1 increase in price of Ice-Cream Cones increases quantity of cones supplied. Change in A shift in the supply curve, either to the left or right. Caused by a change in a determinant other than price. 6

7 of Ice- Cream Cone S $3. C A A rise in the price of ice cream cones results in a movement along the supply curve of Ice- Cream Cones of Ice- Cream Cone S 3 Decrease curve, S 1 curve, S 2 in supply Increase in supply of Ice- Cream Cones Table 2 Variables That Influence Sellers 7

8 SUPPLY AND DEMAND TOGETHER Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. Equilibrium The price that balances quantity supplied and quantity demanded. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium The quantity supplied and the quantity demanded at the equilibrium price. On a graph it is the quantity at which the supply and demand curves intersect. SUPPLY AND DEMAND TOGETHER Schedule Schedule At $2., the quantity demanded is equal to the quantity supplied Equilibrium Surplus When price > equilibrium price, then quantity supplied > quantity demanded. There is excess supply or a surplus. Suppliers will lower the price to increase sales, thereby moving toward equilibrium. Shortage When price < equilibrium price, then quantity demanded > the quantity supplied. There is excess demand or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium. Law of supply and demand The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. Three Steps to Analyzing Changes in Equilibrium Decide whether the event shifts the supply or demand curve (or both). Decide whether the curve(s) shift(s) to the left or to the right. Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. 8

9 of Ice- Cream Cone surplus $2. Equilibrium price Equilibrium shortage Equilibrium quantity of Ice- Cream Cone of Ice-Cream Cones 1. Hot weather increases the demand for ice cream... $2.5 New equilibrium Initial in a higher equilibrium price... D D 7 1 of Ice-Cream and a higher Cones quantity sold. 9

10 Shifts in Curves versus Movements along Curves A shift in the supply curve is called a change in supply. A movement along a fixed supply curve is called a change in quantity supplied. A shift in the demand curve is called a change in demand. A movement along a fixed demand curve is called a change in quantity demanded. of Ice- Cream Cone S 1. An increase in the price of sugar reduces the supply of ice cream... S $2.5 New equilibrium 2. Initial equilibrium in a higher price of ice cream and. a lower quantity sold. of Ice- Cream Cones Table 4 What Happens to and When or Shifts? 1

11 Summary Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price. The demand curve shows how the quantity of a good depends upon the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward. In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts. The supply curve shows how the quantity of a good supplied depends upon the price. According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward. In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts. Market equilibrium is determined by the intersection of the supply and demand curves. At the equilibrium price, the quantity demanded equals the quantity supplied. The behavior of buyers and sellers naturally drives markets toward their equilibrium. To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the even affects the equilibrium price and quantity. In market economies, prices are the signals that guide economic decisions and thereby allocate resources. Chapter 5: Elasticity and Its Applications Elasticity... allows us to analyze supply and demand with greater precision. is a measure of how much buyers and sellers respond to changes in market conditions THE ELASTICITY OF DEMAND elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. elasticity of demand is the percentage change in quantity demanded given a percent change in the price. The Elasticity of and Its Determinants Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon tends to be more elastic : the larger the number of close substitutes. if the good is a luxury. 11

12 the more narrowly defined the market. the longer the time period. Computing the Elasticity of The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. elasticity of demand = Percentage change in quantity demanded Percentage change in price Example: If the price of an ice cream cone increases from $2. to $2.2 and the amount you buy falls from 1 to 8 cones, then your elasticity of demand would be calculated as: ( 1 8) 1 1 2% = = ( ) 1 1% 2 2. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. elasticity of demand = ( Q2 Q1 )/[( Q2 + Q1 ) / 2] ( P P)/[( P + P)/ 2] Example: If the price of an ice cream cone increases from $2. to $2.2 and the amount you buy falls from 1 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: ( 1 8) ( 1 + 8)/ 2 ( ) ( )/ 2 22% = =. 95%. 232 The Variety of Curves Inelastic demanded does not respond strongly to price changes. elasticity of demand is less than one. Elastic demanded responds strongly to changes in price. elasticity of demand is greater than one. 12

13 $5 4 Computing the Elasticity of E D (1-5) (1 + 5)/2 = ( ) ( )/2 67 percent = - 22 percent = -3 is price elastic 5 1 Perfectly Inelastic demanded does not respond to price changes. Perfectly Elastic demanded changes infinitely with any change in price. Unit Elastic demanded changes by the same percentage as the price. Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. (a) Perfectly Inelastic : Elasticity Equals $ An increase in price leaves the quantity demanded unchanged. 13

14 (b) Inelastic : Elasticity Is Less Than 1 $5 1. A 22% increase in price leads to an 11% decrease in quantity demanded. (c) Unit Elastic : Elasticity Equals $5 1. A increase in price leads to a 22% decrease in quantity 14

15 (d) Elastic : Elasticity Is Greater Than 1 $5 1. A 22% increase in price leads to a 67% decrease in quantity demanded. (e) Perfectly Elastic : Elasticity Equals Infinity 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. 15

16 Total Revenue and the Elasticity of Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q $4 P P Q = (revenue) Q 1 Elasticity and Total Revenue along a Linear Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Figure 3 How Total Revenue Changes When Changes: Inelastic An Increase in price from $1 to $3 leads to an Increase in total revenue from $1 to $24 $3 $1 Revenue = $1 1 Revenue = $

17 Elasticity and Total Revenue along a Linear Curve With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Figure 4 How Total Revenue Changes When Changes: Elastic An Increase in price from $4 to $5 leads to an decrease in total revenue from $2 to $1 $5 $4 Revenue = $2 Revenue = $1 5 2 Elasticity of a Linear Curve Income Elasticity of Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. 17

18 Computing Income Elasticity Income elasticity of demand = Percentage change in quantity demanded Percentage change in income Income Elasticity Types of Goods Normal Goods Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, furs, and expensive foods. THE ELASTICITY OF SUPPLY elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. (a) Perfectly Inelastic : Elasticity Equals $5 1. An increase in price leaves the quantity supplied unchanged. 18

19 (b) Inelastic : Elasticity Is Less Than 1 $5 1. A 22% increase 4 in price leads to a 1% increase in quantity supplied. (c) Unit Elastic : Elasticity Equals 1 $5 1. A 22% increase in price leads to a 22% increase in quantity supplied. 19

20 (d) Elastic : Elasticity Is Greater Than 1 $5 1. A 22% increase in price leads to a 67% increase in quantity supplied. (e) Perfectly Elastic : Elasticity Equals Infinity 1. At any price above $4, quantity supplied is infinite. $4 2. At exactly $4, producers will supply any quantity. 3. At a price below $4, quantity supplied is zero. Determinants of Elasticity of Ability of sellers to change the amount of the good they produce. Beach-front land is inelastic. Books, cars, or manufactured goods are elastic. Time period. is more elastic in the long run. 2

21 Computing the Elasticity of The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. elasticity of supply = Percentage change in quantity supplied Percentage change in price THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties? Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes. Figure 8 An Increase in in the Market for Wheat of Wheat leads to a large fall in price When demand is inelastic, an increase in supply... S 1 S 2 $ of Wheat and a proportionately smaller increase in quantity sold. As a result, revenue falls from $3 to $22. 21

22 Compute the Elasticity of E D = 1 11 ( ) / ( )/ 2 = is inelastic Summary elasticity of demand measures how much the quantity demanded responds to changes in the price. elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price.. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets.,, and Government Policies,, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. One of the roles of economists is to use their theories to assist in the development of policies. CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. Ceiling A legal maximum on the price at which a good can be sold. Floor A legal minimum on the price at which a good can be sold. 22

23 How Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage. Figure 1 A Market with a Ceiling (a) A Ceiling That Is Not Binding of Ice-Cream Cone Equilibrium price $4 3 ceiling 1 Figure 1 A Market with a Ceiling Equilibrium quantity of Ice-Cream Cones (b) A Ceiling That Is Binding of Ice-Cream Cone Equilibrium price $3 2 Shortage ceiling of Ice-Cream supplied demanded Cones 23

24 How Ceilings Affect Market Outcomes Effects of Ceilings A binding price ceiling creates shortages because QD > QS. Example: Gasoline shortage of the 197s nonprice rationing Examples: Long lines, discrimination by sellers How Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus. Figure 4 A Market with a Floor (a) A Floor That Is Not Binding of Ice-Cream Cone Equilibrium price $3 2 floor 1 Equilibrium quantity of Ice-Cream Cones 24

25 Figure 4 A Market with a Floor (b) A Floor That Is Binding of Ice-Cream Cone Surplus $4 3 floor Equilibrium price 8 12 demanded supplied of Ice-Cream Cones How Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. When the market price hits the floor, it can fall no further, and the market price equals the floor price. A binding price floor causes... a surplus because QS > QD. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay. 25

26 Figure 5 How the Minimum Wage Affects the Labor Market Wage Labor Equilibrium wage Equilibrium employment Labor demand of Labor Figure 5 How the Minimum Wage Affects the Labor Market Wage Minimum wage Labor surplus (unemployment) Labor Labor demand demanded supplied of Labor TAXES Governments levy taxes to raise revenue for public projects. How Taxes on Buyers (and Sellers) Affect Market Outcomes Taxes discourage market activity. 26

27 When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. Summary controls include price ceilings and price floors. A price ceiling is a legal maximum on the price of a good or service. An example is rent control. A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage. Taxes are used to raise revenue for public purposes. When the government levies a tax on a good, the equilibrium quantity of the good falls SUMBER RUJUKAN N. Gregory Mankiw. 27. Principle of Economics, 4th Edition, Thomson South- Western 27